Why are the markets obsessed with the Fed?

  • The Nasdaq 100, which is an index that tracks the biggest names in U.S. tech stocks, fell 8.5% in January — its biggest monthly drop since December 2018.
  • Also last month, the S&P 500, an index that tracks the performance of the top 500 companies in the US stock market, fell into a “technical correction”. A “technical correction” occurs when the price of an asset falls 10% or more from its recent high.
  • The benchmark for the dollar (DXY) broke above the 97.0 mark – a level not seen since July 2020 (ah, the good old days of being locked up at home, like the rest of the world).

Many of these wild swings in the markets are blamed on the Fed!

What is the Fed and what does it do?

The Federal Reserve is the central bank of the United States of America. It is in charge of the financial system (think of the banks and other institutions that lend or take deposits) of the largest economy in the world, which makes the Fed the most important central bank.

One of the main tasks of the Fed is to ensure that the prices paid by American consumers do not rise too much too quickly.

Unfortunately for consumers, this is happening a lot lately. In December 2021, inflation in the United States increased by 7% compared to December 2020 prices. This is the largest increase in the consumer price index (the CPI measures the rate of inflation). inflation) since 1982. The January 2022 CPI is expected to climb even higher, perhaps 7.3%.

Of course, the Fed wants to protect the public and ensure they can continue to spend money to help the economy grow. When things get too expensive, consumers may not be able to buy as many goods and services. When overall spending experiences a sharp drop in an economy, it would negatively affect the revenue that businesses and producers can obtain, which could lead to cost reductions, job losses, and more.

Out of control inflation is bad news for the economy.

Why is inflation soaring?

As economies continue to open up and outpace the pandemic, people are now able to spend more of their money on goods and services (e.g. dining out, taking vacations, upgrading their laptops when they return to the office, etc.).

However, many suppliers are still disrupted by Covid-19. Think of a factory or port in Asia that has to temporarily close due to an epidemic. This means that a particular product cannot be produced or shipped, causing delays for customers who want it now. Or consider a chef at a restaurant who is confirmed to be Covid-19 positive, meaning all kitchen staff who were in close contact must quarantine. Local diners would then have one less place to dine. Also, consider that many people have become reluctant to return to work since the pandemic.

This shortage of workers has forced many companies to increase their wages to attract more workers so that they can meet the growing demand. Ultimately, many of these companies want to pass this higher payroll on to their customers; hence the price increase.

In short, too much money in search of still scarce goods/services = galloping inflation.

How does the Fed plan to control inflation?

  1. Rising interest ratesWhen interest rates rise, it becomes more expensive to borrow money. Also, people may have more incentive to park more money to earn higher interest rates.

    This results in less waste of money in an economy (reduction in the money supply). As a result, producers and suppliers may then be forced to lower their prices to induce customers to continue buying their goods and services. Hence the control of inflation (hopefully).

    As things stand, markets expect the Fed to raise interest rates by 25 basis points from near zero to 0.25% on March 16.

  2. Quantitative tightening

    QT is when the Fed stops creating money out of thin air to buy bonds issued by banks. When the Fed stops buying these bonds, it essentially reduces the money banks have to lend to people (reducing the money supply). When businesses/consumers have less borrowed money to spend, it is hoped that the reduced money supply will also help lower consumer prices.

    Since the pandemic, the Fed has doubled its balance sheet to nearly US$9 trillion (that’s the number 9 followed by 12 zeros). In short, that’s a lot of money that could be sucked out of the markets/financial system, which worries investors and traders alike.

How does rising interest rates/quantitative tightening affect markets?

  • Tech/growth stocks fell

    The stock prices of many tech companies are valued based on how much they could potentially earn in the future, with little to no earnings to show for now. Much of this growth may depend on how cheap it is to borrow money to grow the business.

    As interest rates rise, the borrowing costs of these so-called “growth stocks” also rise in tandem. With more money needed to repay these loans, rather than using that money to expand the business, this suggests that potential profits in the future may be lower. As a result, tech/growth stocks have fallen drastically in recent weeks.


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